World Development. Vol. 22, No. 9, pp.

1393-141 I, 1994
Pergamon Elsevier Science Ltd
Printed in Great Britain

0305-750x(94)00053-0

The Informal Sector and the Macroeconomy:

A Computable General Equilibrium Approach
for Peru
BRUCE KELLEY *
Florida International University, Miami

Summary.- This paper examines the macroeconomic implications of the informal sector in Peru
through the use of a structuralist, computable general equilibrium model. The lack of formal sector
employment drives informal activity while formal and informal output are treated as imperfect
substitutes. Simulations show that informal activity reduces the Keynesian multiplier and complicates
distributional issues as the income of formal workers and informal producers can move in opposite
directions. A final simulation highlights the limitations of strategies designed to promote the informal
sector. Total output and income of informal producers decline following an increase in productivity in
these processes.

1. INTRODUCTION the informal sector, a common policy designed to

In recent years the informal sector has drawn con-
siderable attention due to a congruence of political,
economic and social forces. In general the bulk of this
research has focused on the microeconomic aspects of
the informal sector or provided descriptive case stud-
ies of informal sector workers or firms.’ Little is
known about the macroeconomics role of the informal
sector such as its effect on the macro adjustment
process or the impact of macro policy on these activi-
ties. One consequence of this is that programs
designed to aid informal producers in the developing
world are adopted without regard to their macroeco-
nomic implications.
This paper analyzes the macroeconomic role of
the informal sector through the use of a multisector,
computable general equilibrium (CGE) model for
Peru. The model follows the structuralist tradition
formalized by Taylor (1979, 1983 and 1991). but
extends these models by differentiating between for-
mal and informal production in both the labor and
product market. The advantage of the CGE method-
ology for this study is that it captures the structural
aspects that drive informal activity as well as differ-
ences between the informal and formal sector and
heterogeneity within the informal sector. In the
model, the lack of formal sector employment is
responsible for informal activity while output of the
two sectors are treated as imperfect substitutes.
Model simulations are then used to analyze how
informal activity affects the macroeconomic and dis-
tributional impact of the heterodox policies imple-
mented by Alan Garcia in 1985. A final simulation
examines the effects of capital accumulation within
help informal producers.
The simulations illustrate the various channels
through which informal activity affects the macro
economy. The first simulation shows how competi-
tion between formal and informal output reduces the
Keynesian multiplier. The second simulation high-
lights the role of relative prices and the importance
of substitution between the two sectors in the prod-
uct and labor markets. Following an increase in for-
mal sector wages, informal output rises and formal
production falls. Informal activity complicates politi-
cal economy issues in these simulations since the
real incomes of informal producers and formal sector
workers move in opposite directions. The final simu-
lation examines the argument, popularized in Peru
by de Soto (1986) and his Institute de Lihertud J
Demouacia (ILD), that free of government imposed
barriers, informal producers would prosper. The
macroeconomic implications of this much-touted
“other path” are seen to undermine the microeco-
nomic logic as higher informal sector productivity
results in a deterioration of the terms of trade and
income in this sector. Thus, while informal activity
will continue to play an important role in Peru, the
paper concludes that this sector should not be viewed
as the key to economic growth and improved living
standards for Peruvians.
Section 2 discusses the definition of the informal
sector, identifies the linkages between the informal
*The author would like to thank Bill Gibson, Robert Cruz,
Maria Willumsen and the anonymous referees of the journal
for valuable comments on earlier drafts of this paper.

1393
1394 WORLD DEVELOPMENT
sector and the rest of the economy and establishes
the stylized facts to be incorporated into the model.
In section 3 the mode1 is presented where special
attention is given to the informal sector’s role.
Section 4 develops the Social Accounting Matrix
(SAM) with emphasis on data issues regarding the
informal sector. The model is then used to simulate
the economy’s response to three policy shocks: a rise
in investment, formal sector wage increases and
greater informal sector productivity. The goal of
these simulations is to understand how the informal
sector affects the macroeconomic adjustment
process, and in turn how macroeconomic changes
affect the informal sector. The conclusion summa-
rizes these results and draws out some of the associ-
ated political implications.
2. THE INFORMAL SECTOR
One of the most striking features of the informal
sector literature is the number of way in which this
term has been used. Surveying the literature, Peattie
(1987) suggests that the term’s ambiguity is largely
responsible for its wide acceptance. Differences
appear at the most basic level. the unit of analysis,
where the informal sector has been defined with
respect to commodities, markets, activities. enter-
prises, institutions and individuals. Even where the
informal sector’s domain is agreed upon, competing
definitions and motivations exist. These difficulties
expand considerably when evaluating data issues as
discussed below.
The CGE model is compatible with various con-
ceptualizations of the informal sector.’ Given that
CGE methodology is built around markets (both
goods and factor) and production (processes) it is
necessary to define the informal sector with respect
to both of these dimensions. This can be done in a
variety of ways following the theoretical work on
this topic. For example, Peattie defines informal
goods such as housing. Gibson and Kelley (1994)
Informal
process Type of product
Light manufacturing simple metalworking furniture
Textiles tailored suits sweaters
Diverse services food preparation personal services
repair services
Consruction housing
Surface transportation taxis. buses light trucking
Commerce mostly retail
*As a percent of total output of each good in base SAM. Numbers do not sum to IOO% due to rounding. Figure\ developed
by author as described in section 4.
differentiate between production processes based on
profitability while Portes. Castells and Benton
(1989) look at the informal sector in a manner paral-
lel to segmented labor market theories.
In this paper the informal sector is limited to cer-
tain legal goods and services that are exchanged in
markets. This condition excludes production for own
consumption as well as illicit goods, such as cocaine,
from the informal sector since the unique structure
and motivation of these activities would significantly
muddle the concept.’ In our model informal produc-
tion is limited to six goods and services that arc
listed, along with some relevant characteristics (See
Table I).”
While the preceding discussion limits the goods
produced by the informal sector, it does not provide
a definition of such production. In the literature
informal processes have been defined by legal status
(de Soto, 1986). production technology (Carbonetto
and Carazo. l986), non-normal profit rates (Gibson
and Kelley, 1994) or the organization and control of
production (Kelley, 1990) while empirical studies
typically use firm size as a proxy for the informal
sector. This paper will incorporate a number of these
characteristics into the picture of the informal sector
developed here.
First, informal production is organized around an
individual, family or small group of friends. This
means that the direct producer controls the produc-
tion process and receives the net product whereas
formal sector workers earn a wage. The technical
aspects of production also differ between sectors
with informal processes characterized as labor-inten-
sive reflecting the scarcity of both physical and
human capital. For Peru, Carbonetto and Carazo
( 1986) estimate the capital-worker ratio to be $500
in the informal sector and $20,000 in the formal sec-
tor while labor productivity in the latter is twice that
of the former. A third stylized fact associated with
the informal sector involves its relationship with the
state. De Soto (1986) is largely responsible for the
current popularity of this theme. but the informal
‘/c of output
from IS
40 II X
37 14 12
19 12 26
7 3 5
43 23 I0
36 36 38
 INFORMAL SECTOR AND MACROECONOMY
sector’s legal status has long been noted.’ Although
his thesis of excessive government regulation as the
sole cause of informal activity remains controversial,
few deny that informal enterprises typically violate
regulatory statutes and pay little taxes. While such
behavior results in higher disposable income in the
short run, it also introduces problems regarding
investment, property rights and security that limit
growth. Estimates concerning the income of infor-
mal producers always indicate informal producers
earn less than formal workers.h Theoretical explana-
tions of these differences include formal sector
unionization and labor legislation (Mazumbar, 197.5)
labor heterogeneity and efficiency wage arguments
(Bardhan, 1988).
A final difference to discuss involves the output
of the respective sectors. While formal and informal
output are similar, examples of product differentia-
tion and imperfect substitutability between the two
sectors abound. Informal merchants sell goods in
smaller quantities, offer different quality goods
(fresher fruit) and occupy different locations (streets)
than formal retailers.’ Another example involves
goods, such as alpaca sweaters or expensive furnish-
ing, where limited market size precludes efficient
formal sector production, The small size and flexible
nature of informal production give these producers
an advantage in filling such niche markets. Repair
services and customized manufacturing are concen-
trated in the informal sector for this reason. In order
to capture these differences in the model, the output
of the two sectors are treated as imperfect substitutes
and aggregated into a composite good that is
exchanged in the market. Relative prices and the
degree of substitution between the output of the
respective sectors determine the composite good’s
makeup and each sector’s output. As relative prices
shift, the composition of the composite commodity
changes which has important macroeconomic
impacts in the simulations.
These unique characteristics of the informal sec-
tor suggest that the motivation of production, invest-
ment and savings decisions, supply elasticities and
distributional issues will vary between formal and
informal sector. Such differences, however, do not
provide the motivation for, or a theory of, informal
activity. This is found in the relationship between the
informal sector and labor market. Higher wages,
greater stability of income and superior working
conditions make formal sector employment more
desirable than informal activity. Due to rapid popula-
tion growth, economic stagnation and the capital-
intensive nature of formal production, however, the
formal sector does not employ the entire labor force.
With minimal savings and the absence of govern-
ment-sponsored transfer payments, workers who
cannot find formal sector employment are forced to
1395
develop alternative income sources. While some turn
to criminal or other activities, the vast majority of
this surplus labor pool in developing countries enters
the informal sector. “Full employment” exists, but
this is achieved through changes in the level of infor-
mal activity rather than by adjustments in the formal
labor market.
3. THE MODEL
This section describes the CGE model and how it
reflects the major structural characteristics of the
Peruvian economy and the stylized facts of the infor-
mal sector discussed above. Before exploring the
model it is helpful to discuss the CGE methodology
and its suitability for analyzing this issue. CGE mod-
els are essentially complicated versions of the circu-
lar flow diagram taught in introductory economics
where the system of equations maps the flow of
goods, services and factors of production between
the various economic agents in the economy for a
given time period. Markets clear ex-post since actual
supply and demand must be equal, but this identity
can be fulfilled by changes in output, price or some
other variable where the specific adjustment mecha-
nism reflects the characteristics of the respective
market as well as macroeconomic conditions. Along
with these sectoral balances, the budget constraints
for the respective economic agents as well as macro-
economic identities, such as the savings-investment
balance, form the core of the CGE model.
In addition to the internal consistency require-
ments, there are several other advantages of the CGE
methodology for our study of the informal sector.
First, the model captures both the microeconomic
reaction of individuals to, and the macroeconomic
impact of, an exogenous shock. For example, a
change in relative prices causes migration within the
informal sector, altering the level and composition of
output, which affects other variables such as income
distribution. The CGE methodology also allows sig-
nificant sectoral disaggregation which is necessary to
capture the technological and structural differences
that exist across industries in a developing economy
such as Peru. Sectoral disaggregation is particularly
important in this study since it allows the model to
capture differences within the informal sector, a crit-
ical feature of these activities. The drawback of such
disaggregation is that it makes the model too compli-
cated to solve analytically so empirical simulations
are required. The CGE methodology also forces the
modeler to be explicit about market structure and the
connection between the empirical model and eco-
nomic theory. Not only does this demystify the
underlying economic assumptions, it also makes the
transmission mechanism and the connections
I396 WORLD DEVELOPMENT
between the endogenous variables more transparent.
Finally, and most relevant for this study, the CGE
model has distinct advantages regarding data
requirements. Instead of requiring a long time series
as in an econometric study, the CGE model only
needs data for one point in time which are incorpo-
rated into a consistent macroeconomic framework
according to explicit assumptions concerning the
informal sector, parameter values and economic
theory. While the data requirements are still daunt-
ing. the alternative of an extended time series does
not exist making econometric analysis impossible.
With this understanding of CGE methodology.
we can turn to the actual model. To save space, the
actual equations are given in Appendix A. The
model has IX domestic goods, six of which are com-
posite goods made up of formal and informal output,
and one noncompetitive imported good. There are
five economic actors: three domestic classes (formal
sector workers, capitalists and informal producers)
plus the government and foreigners. Total capital
stock and its distribution across industries is fixed.
Labor is assumed to move costlessly across pro-
cesses and between the formal and informal sector.
In the goods market sectoral balance is given by
the equality of supply and demand where supply is
determined according to structural characteristics.
For each good or service except commerce, total
demand is made up of intermediate, consumption,
investment, government and export demand.
Intermediate demand is given by the Leontieff tech-
nology while consumption is linear in expenditure.”
Both investment and government demand are given
in real terms while export demand depends upon the
type of good as described above.
Commerce. good IS, is treated differently since
demand for this service is a derived demand based
on commercial margins associated with the purchase
of other goods4 Commercial margins are fixed in
physical units and given in the National Accounts for
each good and type of demand. The commercial
markup is determined by the physical margin multi-
plied by the price of commercial services where the
difference between producer and retail price goes to
merchants for their services. If H,, represents the
physical margin on good i when purchased by
process ,;. H,, the physical margin on good i when
purchased by final demand type/’ and D,, the final
demand of good by demand type,/: total demand for
commercial services is given by:
xi, = ; ; a&X,+ ;j ;: O,,Di,
,=I ,=I ,=I ,=I
The government collects income and sales tax
from the formal sector while their expenditures are
fixed exogenously. The government is also rcsponsi-
hle for two production processes (public infrastruc-
ture and government services) where the difference
between revenue and cost is the profit (or loss) of
parastatal enterprises. I0 The fiscal deficit is consid-
ered to be nonbinding and determined endogenously.
in the external sector. resource-based goods
(agriculture, minerals and petroleum) account for
75% of export earnings reflecting Peru’s reliance on
traditional exports. Structural constraints determine
this supply in the short run and price is given by the
world market following the small country assump-
tion. Exports adjust to clear these markets. The
remaining 25% of exports come from nonresource-
based production. Since exports are a relatively
small portion of demand for these goods, they can be
fixed in real terms. All imports are considered to be
noncompetitive and treated as a separate good. The
external account is balanced by changes in foreign
savings.”
Labor is considered to be homogeneous which
avoids differences retlecting skill, gender and spatial
factors. Due to excess capacity in the formal sector.
labor-output coefficients in this sector are taken as
constant. Labor productivity is also assumed to be
constant in the informal sector since these processes
use so little capital that the marginal product of labor
will not change significantly as workers enter or
leave these processes. In informal processes that
require a significant amount of capital, workers typi-
cally use personal or household assets. For example,
drivers frequently use their own personal vehicles to
provide informal transportation services. In this
sense entry into this process is restricted to individ-
uals who own their own car which means capital-
labor ratios. and thus productivity. will not change
significantly as the number of workers in these
processes change.”
Despite the common assumption concerning
labor productivity, issues concerning income distrib-
ution differ between the two sectors. In the simula-
tions the formal sector wage is fixed by institutional
factors while the imputed wage of informal pro-
ducers is the net product which is determined
endogenously as the difference between price and
intermediate costs. Based on Peruvian data, formal
sector employment is more remunerative than infor-
mal activity in the base SAM.” This difference. con-
sidered the formal sector wage premium, varies
across processes and changes during the simulations
as relative prices and income within the informal
sector shift. Changing relative income within the
informal sector induces informal producers to switch
processes which alters the composition of informal
output as well as the distribution of income between
formal and informal scctorx.
As discussed ahove. formal and informal output
 INFORMAL SECTOR AND MACROECONOMY
are treated as imperfect substitutes and combined
into a composite good using an Armington function
(Armington, 1969). This technique is frequently used
in CGE models to account for differences between
domestic and imported goods (Dervis et al., 1982, p.
224). The strength of such an approach is that it
allows relative prices and the elasticity of substitu-
tion between formal and informal sector output to
determine the composition of the composite good. If
P’, represents the informal-formal price ratio for
good i and o, the elasticity of substitution between
formal and informal output of this good, the portion
of informal output in the ith commodity, $,, can be
expressed as:
4, = f (P, ‘90;) (&ml? <0
As P’, (the relative price of informal output)
increases, formal output replaces informal produc-
tion in the composite commodity where the magni-
tude of this change depends upon the elasticity of
substitution between formal and informal output. As
output becomes more homogeneous (u, increases), a
given change in relative prices will have a larger
effect on the composition of the composite commod-
ity. In the extreme case where u, = CCthe goods are
homogeneous and therefore prices must be equal.
Given the limited data for the informal sector, values
for this parameter cannot be obtained from the litera-
ture. Instead simulations will be run using several
values for this variable in order to show how
changes in this parameter alter the adjustment
process and change the simulation results.‘”
The final aspect concerning the informal sector to
be discussed at this point involves how workers are
distributed between the respective informal pro-
cesses. From our theory of the informal sector, the
number of informal producers is given by the differ-
ence between total labor force and formal sector
employment. Due to the disaggregated nature of the
informal sector in this study, however, we need a
mechanism to allocate producers to the respective
informal processes. This mechanism should reflect
the relative income and barriers to entry associated
with each informal process. The labor allocation
equation can be written as:
18 17
liy/CE- C I& = r,(P, - C k,aJJ
!=I i= I
j=l9,20,...,24
where 1, is the labor-output coefficient for process j.
X, the output of process j, z th: total labor force, c,
(the output price of process j, rl, the cost of input i
to process j and a, the input-output coefficient. The
F, term is a scale term taken from the base SAM
1397
while ~1, is a parameter which reflects barriers to
entry for the respective informal process. Since the
first 18 processes are formal, the term in parentheses
on the left-hand side represents the total size of the
informal sector labor force. The term in parenthesis
on the right-hand side corresponds to the value of the
net product of the informal process which deter-
mines the income of the informal producer. As barr-
ers to entry decline, a, increases so income differ-
ences between informal processes play a larger role
in deciding where labor goes to within the informal
sector. As with the a, term discussed above, no
empirical estimates for this parameter exist so we
will run simulations to check the model’s sensitivity
to this parameter. This will also illustrate how the
reaction of informal producers to a change in relative
prices can alter the macro adjustment process.ls
The presence of informal activity, as well as
other structural characteristics, determine how prices
are formed and markets clear. For resource-based
goods which face a given world price, domestic
prices follow directly since export tariffs, commer-
cial margins and the exchange rate are all fixed.
With price determined in this manner and output
fixed in the short run due to structural constraints,
exports adjust to clear these markets. For the other
formal processes, price is determined by an exoge-
nous markup over costs which is defended by high
tariff barriers and idle capacity.lh For markets limited
to formal production, capacity utilization and output
adjust to equate supply and demand at this price.
In other markets with both formal and informal
production, market clearing is mediated by the
Armington function and the makeup of the compos-
ite good. Formal sector prices are still given by a
markup equation, but the price of informal output is
determined endogenously in order to clear each mar-
ket while maintaining full employment. For a given
set of relative prices, if there is excess supply of a
good produced by the informal sector, the price of
this output will fall causing the informal sector’s
weight in the composite commodity to increase. The
price of the composite good will also fall since it is a
weighed average of informal and formal sector
prices. Equilibrium is reached when a price vector is
found where full employment exists and all markets
clear.
To understand the model’s behavior and the
informal sector’s role in the adjustment process con-
sider an exogenous fall in investment. For resource-
based goods, the fall in domestic demand translates
into greater exports since price is given by the small-
country assumption and output is fixed in the short
run due to structural considerations. Elsewhere for-
mal sector firms respond to this fall in demand by
cutting back production and reducing employment
which translates into a larger informal sector labor
139x WORLD DEVELOPMENT
force and is allocated across the respective processes
according to the labor allocation equation described
above. An increase in the number of informal pro-
ducers and lower demand for their output causes the
price of informal goods to fall which, from the
Armington function, increases the informal sector’s
weight in the composite commodities. The decline in
informal sector price is not uniform which causes
migration within the informal sector as producers
move to where relative prices have increased.
Formal sector output and employment both fall. but
the effect on informal sector output is ambiguous.
Although the number of informal producers has
increased, the sector’s output could fall if there was
enough movement within the sector from high to low
productivity processes.
The macro savings-investment balance now holds
at the lower level of investment as all three forms of
savings (private, government and foreign) fall. The
government balance falls since both direct and indi-
rect taxes depend directly on formal sector output.
The trade balance improves as exports of resource-
based goods increase while imported intermediate
goods fall with formal production. Lower formal
output is also responsible for the fall in private sav-
ings.
4. THE SOCIAL ACCOUNTING MATRIX
Before examining the simulation results, it is nec-
essary to discuss the Social Accounting Matrix (SAM)
which serves as the database for the CGE model as
well as the benchmark from which the simulation
results are measured. The SAM, given in Appendix B.
is built from the latest Peruvian input-output tables
(INE, I986a) and updated from I979 to I985 using the
RAS procedure developed by Stone ( 1954) as well as
additional data provided by the National Accounts
(INE, l986b and 1986~) and BCR (1986). The princi-
pal challenge was to collapse the 70 processes and IO3
commodities of the National Accounts into a more
workable number that reflect the major structural fea-
tures of the Peruvian economy while incorporating
data on the informal sector.
The SAM consists of I8 domestic goods produced
by IX formal processes and six informal processes
plus the noncompetitive imported good. Reading
across the row of the SAM give\ the revenue
received by the producer from the various sources of
demand; intermediate, consumption, investment. gov-
ernment and export demand. This total must equal the
payments made by the respective processes which are
given by reading down the column. For formal sector
firms total costs include intermediate cost\. noncom-
petitive imports, wages, profits, a depreciation term
(savings by the firm), indirect taxes minus any subsi-
dies net of other taxes. Profits are determined residu-
ally to balance the row and column totals. One
unusual aspect of the SAM i\ that commodity flows
are measured in producer prices with a separate entry
for commercial services which reflects the commer-
cial markup or the difference between producer and
retail prices as explained above.
All imported goods are treated as noncompetitive
with domestic production which allows them to be
treated as a separate good and occupy a separate row
in the SAM. Structuralist literature emphasizes the
role of non competitive imports and this assumption
is common in CCE models of small countries such
as Peru.” Import and sales taxes occupy separate
rows in the SAM and differ according to final desti-
nation. Without capital flows, imports minus exports
(the trade balance) equals foreign savings which is
assumed to be endogenous.
There are three domestic classes or economic
groups: formal sector workers in both private and
stateowned enterprises. informal producers, and cap-
italists. Formal sector workers receive wages, pay
income taxes and do not save. Informal producers
receive the net product of the process they operate.
and do not pay income taxes or save.ls Capitalists
receive their income as a residual between the rev-
enue and costs of privately owned firms. They pay a
fixed percentage of their income in taxes. and since
the model lacks a financial side. a constant savings
propensity is imposed.‘” Consumption ad.justs to bal-
ance the household budget equation for each group
and is allocated between 17 domestic goods and the
imported good. based on household consumption
surveys (INE, 1981). Several domestic commodities
as well as the imported good are treated as luxuries
and are only consumed by capitalists.
The government is the I’inal economic actor and
receives its revenue from profits on government-run
processes ( IO and I I ). indirect taxes net of subsidies.
import taxes and other taxes. Government expendi-
ture\ are distributed between domestic goods and
imports where the difference between expenditures
and revenue is the government deficit or surplus.
Without a monetary side, the model implicitly
assumes any deficit is completely monetized. The
macro savings-investment balance, which must hold
via Walras’s Law, can be derived so that total sav-
ings, the sum of private. government and foreign
savings plus depreciation (business savings) equals
the fixed level of investment.
Up to this point, the construction of the SAM has
been fairly standard. This changes with the incorpo-
ration of informal activity, however, as a number of
assumptions must be made in order to maintain the
internal consistency of the SAM and separate value-
added between formal and informal sector. The first
assumption excludes informal output not captured by
 INFORMAL SECTOR AND MACROECONOMY
the National Accounts from the SAM. Although this
imparts a downward bias to the size of the informal
sector, it is essential in order to maintain the SAM’s
internal consistency. The informal sector’s smaller
size should only change the magnitude, not the
direction of change, of the simulations.*” Other
assumptions, built on the stylized facts of the infor-
mal sector, help divide value-added between formal
and informal processes. In the model, informal
processes pay no taxes, do not use imported interme-
diates and operate with so little capital that all depre-
ciation is attributed to the formal sector.
While these simplifications are a starting point,
more information is required in order to derive rea-
sonable estimates for the size, income flows and pro-
duction coefficients for each of the six informal
processes that are consistent with the overall totals of
the National Accounts. First, the labor force is sepa-
rated into formal and informal sectors based on the
National Accounts category of paid and unpaid
employment where the latter group represents infor-
mal producers. These figures provide a reasonable
size for both the total size of the informal labor force
as well as the distribution between the respective
processes.?’ With the informal sector limited to the
six commodities described above, this rule placed
more than 900,000 workers or 90% of the “unpaid,”
nonagricultural labor force in the informal sector
which is close to other estimates of informal
activity.”
Once formal and informal sector employment are
determined, their respective output can be deter-
mined from the relative labor productivities.
Estimates of labor productivity, however, are spotty
and subject to definitional and other problems. For
example, Carbonetto and Carazo (1986) estimate
productivity in the formal sector to be five times
greater than the informal sector, but they define the
informal sector by low productivity. Furthermore,
they do not differentiate according to commodity so
productivity differences could reflect differences in
type of output rather than production technologies.
De Soto and his ILD are another source of data on
the informal sector. Although there are methodologi-
cal errors in their estimates of the informal sector’s
overall size (Rossini and Thomas, 1990) their fig-
ures for productivity differences between formal and
informal processes for individual commodities are
reasonable. Combining these estimates with the out-
put and employment data for each commodity from
the National Accounts gives the relative size of for-
mal and informal output for each commodity. The
absolute levels are then adjusted to match the total
level of output. Note that this approach does not
account for differences in hours worked between for-
mal and informal enterprises as reported by
Carbonetto, Hoyle and Tueros (1987) which implies
1399
this process understates the informal sector’s actual
size.
Once the size of formal and informal output is
established, the value-added reported in the National
Accounts must be assigned to the respective process-
es. This is done by incorporating certain stylized
facts of the informal sector as well as several addi-
tional assumptions. From the stylized facts of the
informal sector all depreciation, imported intermedi-
ates, indirect taxes and wage income can be attri-
buted to the formal sector. Informal income, the net
product of informal processes, is subtracted from
total profits given in the National Accounts. Thus,
the separation of value-added between formal and
informal sector can be reduced to estimating infor-
mal income or net product for each of the six
processes.
In this task, government data on wage and inde-
pendent producer’s income are of limited use since
the latter group usually includes peasants which are
not part of our definition of the informal sector. In
addition, most studies do not account for income dif-
ferentials within the informal sector due to the com-
modity or service produced and the possibility that
formal workers also work in the informal sector.
Estimates of informal income in Peru suggest uni-
form methodology and definition of this sector has
not been established. For example, Rizo Patron
( 198 1) has independent producers earning more than
wage earners in the corresponding formal activity.
Carbonetto (1985) estimates the average income in
the informal sector to equal the minimum wage in
the formal sector or 50% of the average formal sec-
tor wage while Carbonetto, Hoyle and Tueras (1987)
put this figure at 67%. De Soto (1986) estimates
informal producer’s income to be less than half of
what workers make in the formal sector.
Further complicating the data issue is the require-
ment that figures used for the informal sector must
be consistent with the overall data provided by the
National Accounts while reflecting the general char-
acteristics of the informal sector. Since data on the
informal sector come from a number of sources, the
actual figures used in the model had to be estab-
lished via an iterative process in order to make them
consistent with the National Accounts. For example,
formal sector workers were initially assumed to earn
twice as much as informal sector producers, and this
income was subtracted from the profits recorded in
the National Accounts. With all depreciation, sales
tax and imported intermediates attributed to the for-
mal sector, intermediate consumption is given as the
residual between total output and value-added in the
informal sector. This meant, however, that several
informal processes used more domestic intermedi-
ates per unit of output than their formal counterparts,
something that is strongly at odds with the literature
I400 WORLD DEVELOPMENT
on the informal sector. In order to solve this prob-
lem. estimates of the productivity differences
between the two processes were increased in order to
reduce the absolute size of the informal sector. The
income of informal producers relative to the formal
workers in the corresponding process was also
increased in order to increase value-added of the
informal sector. Since intermediate demand is the
difference between total output and value-added.
both of these changes help to reduce intermediate
demand by informal processes.
The final figures concerning the relative income
and productivity figures for the informal sector are
given in Table 2. Several figures merit special atten-
tion. First. the difference in productivity between the
formal and informal process responsible for the ser-
vice “commerce” is much greater than the differ-
ences for other processes. This reflects the lack of
capital and seasonal nature of many r~nhularztes who
swell Lima’s sidewalks, but generate very few sales.
The difference in productivity is also consistent with
the absence of barriers to entry to this process. Note,
however. that despite much lower productivity the
income of informal merchants equals 908 of formal
sector wages in commerce: the same ratio as most
other informal processes. This assumption can be
defended in several ways. First, the nature of com-
merce demands relatively few skills so formal sector
employers are not likely to offer a large wage premi-
um to attract workers. Furthermore. the nature of
informal commercial activity forces informal mer-
chants to work very long hours which lowers the
income differential. Finally. informal merchants also
deal in wholesale trade and to the extent they receive
a return on the capital used in this process, such as a
vehicle. they might even earn more than formal
workers.
The possibility that informal producers receive a
return for the capital used in these processes also
explains why informal producers of transportation
services earn more than workers in the comparable
formal process. The nature of this process requires a
relatively large amount of capital so when the return
on capital is added to labor income, informal pro-
ducers earn more than their formal sector counter-
parts.” Again the ability to differentiate between
informal processes and incorporate stylized facts that
reflect the heterogeneity of the informal sector is a
clear advantage of the CGE methodology.
These revised estimates produce figures for the
informal sector’s relative size and usage of inter-
mediate goods that are more consistent with the
National Accounts. Once the total intermediate cost
for formal and informal process is determined as
explained above, the actual composition of interme-
diate usage must be specified. Again, data on the
input-output structure of informal enterprises are
nonexistent which limits this disaggregation. Formal
and informal processes producing the same good
were assumed to have the same relative input-output
structure so if a formal process used twice as many
intermediate goods per unit of output as its informal
counterpart, then each of its input-output coefficients
would be double that of the informal sector. These
coefficients were then adjusted slightly where casual
empiricism suggested that the relative intensity of
intermediate demand for certain products should dif-
fer between the two processes.
The process described above produced a balanced
SAM for Peru for 1979, the base year for the input-
output table. The SAM was updated to 1985. the
year for this study. using more recent aggregate data
while the RAS procedure was used to update the
input-output coefficients.” Formal sector labor
coefficients are assumed to be constant during this
period, but several changes are likely to have
occurred in the informal sector due to Peru’s eco-
nomic problems. Although data do not exist, such
changes include an increase in the relative size of the
informal sector and a corresponding decrease in the
relative income of these activities due to the large
number of new informal sector producers. As a
result. slight adjustments where made in these fig-
ures for 19X5.
5. THE SIMULATIONS
The simulation results obtained using the CGE
model developed above are discussed in this section.
During the period covered in these simulations the
Garcia government followed a heterodox economic
program built around expansionary fiscal and mone-
tary policy, explicit income redistribution and direct
price controls. The initial results of this package
were encouraging, output increased by 8.5% and
inflation was cut in half during Garcia’s first year in
office. An alliance appeared to be developing
between the government and the private sector
 INFORMAL SECTOR AND MACROECONOMY 1401

which seemed to have potential regarding medium-
term growth. Unfortunately after two years of expan-
sion, cracks appeared in the heterodox program and
when the government failed to address these imbal-
ances, the recovery collapsed and Garcia barely
completed his term amid hyperinflation, tumbling
output and social chaos.25
The first two simulations, an increase in exoge-
nous demand and higher nominal wages, involve
aspects of the heterodox package. Although Garcia
implemented these policies simultaneously, the pol-
icy simulations are done separately in order to isolate
the effects of the respective shock. In these simula-
tions heterodox policy is shown to successfully reac-
tivate production, but efforts to improve income dis-
tribution are complicated by the presence of informal
activity. The last simulation examines the macro-
economic effects of capital accumulation in the
informal sector. The results here suggest that policies
which promote the informal sector are likely to have
adverse indirect effects on informal producers
through the macro adjustment process.
(a) A 10% increase in exogenous demand
The first set of simulations examines the effects
of a 10% increase in government and investment
demand. This corresponds to the initial heterdox
shock and mini-investment boom following Garcia’s
election. The two simulations differ with respect to
a, the parameter which reflects the barriers to entry
for the respective informal process. In simulation B
the value of a was doubled for two informal pro-
cesses (commercial and diverse services) to reflect
the lower entry barriers for these processes.
Both simulations indicate that expansionary pol-
icy is effective which is not surprising given the
model’s basic Keynesian structure. One interesting
result is that both formal and informal output
increased which seems to violate the full-employ-
ment constraint since formal and informal sector
employment are inversely related. This apparent
inconsistency can be explained by labor migration
within the informal sector as producers move from
low to high productivity processes as relative prices
within the informal sector change.
The initial increase in demand causes formal sec-
tor firms to increase output and draw workers from
the informal sector. At the same time, however,
demand for informal output is rising due to the initial
shock and associated multiplier. Higher demand and
lower supply drive up the price of informal output
which is reflected in the 7.3% and 5.3% gain in
terms of trade for the informal sector in the two sim-
ulations. The increase in informal prices, however, is
not uniform since initial shock and subsequent
increase in demand varies across commodities. This
causes informal producers to move to informal
processes where relative prices and income have
increased the most. Because this shift also reflects a

Table 3. A 10% increase in government and investment demand (o/ochange from base SAM)

A* BI

Total GNP 3.0 2.9

Formal sector output 3.1 3.3
Informal sector output 0.2 1.1
Employment
Formal sector employment 3.6 3.4
Informal commerce -1.4 0.0
Savings
Government deficit as % of FS outputS 1.0 0.9
Trade balance 43.2 -40.2
Prices
Overall price level 1.3 1.0
Real exchange rate -6.0 -5.3
Informal sector terms of trade 1.3 5.3
Distribution
Formal sector wages and IS Income as a proportion of total Income 2.4 2.2
IS income as a proportion of total Income 4.8 3.6
FS wages as a proportion of total Income 0.0 0.0
Change in the imputed wage of the IS relative to the FS wage rate 22.2 19.1

*all a and cr equal to one

tall o = 1, some a = 1 and other a = 2
SThis value expressed in absolute terms not percentage change
1402 WORLD DEVELOPMENT
movement from low to high productivity processes,
total informal sector output increases despite
a decline in the number of informal producers.
Migration within the informal sector also
explains the difference between the results of simu-
lation A and B. In the latter CX,was increased for
informal commerce and diverse services to reflect
the relatively low entrance barriers for these pro-
cesses. As a result workers who migrated to more
remunerative informal processes in simulation A
now enter these processes. This is reflected in the
constant number of informal merchants in simulation
B after falling 1.4% in simulation A. Because the
processes with lower entry barriers in simulation B
also have lower productivity and income, the expan-
sionary impact of the initial shock is smaller than in
simulation A. This is apparent in the 3.3% increase
in formal sector employment in simulation B com-
pared to the 3.6% increase in simulation A. The
smaller gain in formal sector employment is then
responsible for the larger (1.1%) increase in informal
output as informal producers still move to the more
productive informal processes. Finally. note that the
larger increase in informal output in simulation B is
responsible for the smaller gain in the terms of trade
for the informal sector here. These results highlight
how the microeconomic responses of informal pro-
ducers, as well as macroeconomic conditions, affect
the structure of informal production.
The presence of informal activity also affects
issues of income distribution. In both simulations the
distribution of income improves as the share of
income received by formal and informal sector
workers increased. In simulation A. however, this
share rose by 2.4% while in simulation B it was
limited to 2.2% due to the smaller gain in formal
sector employment and informal sector terms of
trade. Within the working class the distribution of
income also improved as informal producer’s
income increased relative to the formal sector wage
rate by 22.2% and 19.1%. respectively.
Finally, total savings increase so that the savings
investment balance holds at the higher level of
investment although the various types of savings
respond differently. Private savings increased since
this is directly related to formal sector profits which
increased with formal sector output. This increase,
however, is partly offset by a larger government
deficit which increased from 0. I% to I .O% of formal
sector output in simulation A. This combination
means the trade balance must fall. Rising demand
reduces exports of resource-based goods while
greater formal output requires more imported-inter-
mediates. Combined with a 6.0% appreciation in the
real exchange rate, these factors produce a 43%
decrease in the trade balance.
In sum. these two simulations indicate that infor-
ma1 activity does not change the basic expansionary
impact of the heterodox package. Formal output
increases in response to higher aggregate demand.
but informal activity reduces the multiplier since
informal producers move into the formal sector. The
decline in the number of informal producers alters
relative prices, and thus output, within the informal
sector which has important distributional effects.
Informal producers who either moved to the formal
sector or experienced terms of trade improvements
benefit. On the other hand workers who already held
formal sector jobs saw their real wages decline due
to the increase in the general price level ( 1.2% and
1.0% in the two simulations). With the ruling APRA
party relying upon this group for political support,
such a reduction in real wages was politically un-
acceptable. In fact, in order to solidify his base of
support, Garcia needed to increase real wages for
those already employed. The consequences of such a
policy within this model are examined next.
The second set of simulations examines the
effects of a 10% increase in the formal sector wage
rate. Wage-led growth is a common theme in struc-
turalist models where redistributing income toward
classes with higher consumption propensities sparks
increased demand and output (Taylor, 1983). With
Garcia’s promises to improve Peru’s distribution of
income and the influence of structuralist thought on
his government, this policy found a receptive audi-
ence. Simulations show, however, that when infor-
mal activity is included, this policy has the exact
opposite result. Higher nominal wages lead to
stagflation and a deterioration in most measures of
income distribution in Table 4.
The key to these surprising results is found in the
behavior of the informal sector. Higher formal wages
are passed along in the form of higher prices for for-
mal output which, from the Armington function,
allows the informal sector to increase its weight in
the composite commodity. While higher formal
wages do cause demand and formal sector output to
increase, this is exactly offset in simulation A by the
reduction in output reflecting lower output due to
competition from the informal sector. As u, the elas-
ticity of substitution between formal and informal
output, changes, the relative magnitude of these two
forces also changes. Simulation B shows that an
increase in o,, reflecting greater similarity between
formal and informal sector output, increases the
importance of price differences and competition
between sectors causing formal sector output to
decline in simulation B.
The informal sector also changes the distribu-
 INFORMAL SECTOR AND MACROECONOMY 1403

Table 4. A 10% increase in formal sector wages (% change from base SAM)

A* Bt CS
Total GNP 0.4 0.3 0.2
Formal sector output 0.0 -0.1 a.1
Informal sector output 2.3 2.6 2.5
Employment
Formal sector employment 0.2 0.1 0.0
Informal commerce 2.4 2.9 3.0
Savings
Government deficit as % of FS outputs 0.8 0.8 0.6
Trade balance -8.6 -6.9 -5.2
Prices
Overall price level 3.3 3.2 3.4
Real exchange rate -5.5 -5.3 -5.5
Informal sector terms of trade -0.2 4.8 -0.8

Distribution
Formal sector wages and IS Income as a proportion of total Income 4.3 4.2 4.2
IS income as a proportion of total Income 0.3 0.0 0.0
FS wages as a proportion of total Income 5.1 5.2 5.2
Change in the imputed wage of the IS relative to the FS wage rate -4.8 -5.5 -5.8

*A - all a and cr equal to 1.

tB-alla= l,someu= landothero=2.
$C-alla= l,someu= 1andothera=2.
§This value is expressed in absolute terms, not percentage change.

tional impact of this policy. Higher nominal wages
increase formal sector workers share of output by
5.1%, but informal producers are adversely affected
due to the decline in their terms of trade. In simula-
tion A, the informal sector’s terms of trade falls by
0.3% which, combined with higher nominal wages
in the formal sector, results in a 4.8% decline of the
informal producer’s imputed wage relative to the
formal sector wage. Thus while the popular class’s
share of total income increased by 4.3%, inequality
within this group also increased. These results high-
light the difficulty of improving the distribution of
income in the presence of a large informal sector.
Simulation B and C test the model’s sensitivity to
these values as well as illustrate how these parame-
ters affect the adjustment process. In simulation B, u
was doubled to show the effect of greater similarity
between formal and informal output. Not surpri-
singly, the expansionary impact of higher wages was
reduced as the importance of competition between
formal and informal output increased. From the
Armington function, a higher u results in a larger
share of informal output in the composite commo-
dity for a given increase in formal sector prices. As a
result, total formal sector output fell slightly (a.1 %)
while informal output rose by 2.6%. The larger
increase in informal output produces a greater
decline in the terms of trade in simulation B, -0.8%
vusus -0.3% in simulation A. This is counter intu-
itive since partial equilibrium analysis holds that as
products become more homogenous, their prices
should converge. The macroeconomic consequences
of the initial shock, however, outweigh this effect on
output prices which once again highlights the advan-
tage of analyzing informal activity within a macro-
economic framework.
Simulation C analyzed the model’s sensitivity to
barriers to entry for the various informal processes
by increasing a,for two informal processes (com-
merce and diverse services). A higher a, increases
the importance of income differences between infor-
mal processes in the labor allocation process and
thus reflects lower entry barriers. This reduces the
expansionary impact of higher nominal wages since
the reduction of entry barriers into processes with
low productivity will increase migration into these
processes. For example, the number of informal mer-
chants rose by 3.0% in simulation C compared to
2.4% in simulation A. The larger increase in these
two informal processes is also responsible for the
greater decline in the real income of informal pro-
ducers in simulation C since these are low-income
processes. The different results highlight the reaction
of informal producers to a change in economic con-
ditions and shows the importance of differentiating
between informal processes as well as between the
formal and informal sector.
An examination of the macro savings-investment
I404 WORLD DEVELOPMENT

labor productivity for all informal processes in order

to capture the effects of programs designed to pro-
mote capital accumulation here. Such programs have
A*
been popularized by De Soto who sees the informal
Total GNP
sector as the only alternative or “other path” to the
a.1
Formal sector output 3.3 failed statist policies of the past. In this view once
Informal sector output 4.6 government barriers facing the informal sector arc
lifted, investment will flow into these processes
Employment
resulting in economic growth and greater economic
Formal sector employment -0.2
Informal commerce -6.6 welfare for these producers. This simulation exam-
ines whether capital accumulation in the informal
Savings
sector, as reflected in higher labor productivity, is
Government deficit as % of FS outputt -0.8
sufficient to fulfill such promise\. As Table 5 indi-
Trade balance I .6
cates. the macroeconomic impact of such a change is
Prices likely to undermine its microeconomic logic. In this
Overall price level 0.9
simulation total output falls. the informal sector’s
Real exchange rate I .9
Informal vector terms of trade
terms of trade deteriorate and income distribution
-5.2
worsens.
Distribution The initial response to this exogenous shock is an
Formal sector wages and IS Income -0.4
expansion of informal output, but without new injec-
as a proportion of total Income
IS income as a proportion of total Income
tions this causes the price of informal output to fall.
4.0
FS wages as a proportion of total Income 0.4 From the Armington function this change in relative
Change in the imputed wage of the IS -6.4 prices leads to an increase in the informal sector‘s
relative to the FS wage rate share and a corresponding decrease in the formal
sector’s share of the composite good. This means
*A - all CIand (r equal to I. formal sector employment decreases which leads to
tThia value is expressed in absolute terms. not percentage a further increase in informal output as displaced
change. workers enter this sector. A second round of change\
in relative prices and formal sector output follows.
balance indicates other potential problems with this At the new equilibrium formal sector output ha\
strategy as the government deficit and foreign savings fallen by 4.X+, but this is not spread evenly across
both rise. The trade balance deteriorates as the real the processes. In fact some formal processes, those
exchange rate appreciates and domestic demand for that do not compete with the informal sector. experi-
resource-based goods increases following the rise in ence an increase in demand due to lower output
nominal wages. The government deficit also increases prices reflecting the savings on intermediate costs.
as expenditures rise in line with domestic inflation. With the decline in formal output. the govern-
and tax revenue stagnates along with formal output. ment deficit is expected to increase. Table 5 indi-
This simulation clearly shows how informal cates. however, that the government deficit. which
activity limits the potential of wage-led growth as a equaled 0. I% of formal sector output in the ba\c
short-term strategy for increasing output and improv- SAM. actually moved into a small surplus (0. I %,) in
ing the income distribution. Higher formal sector the simulation. This is the result of lower nominal
wages and prices allow the informal sector to expenditures reflecting the 0.9% decline in prices
increase their share of the composite good which off- which more than offset the 0.3% fall in tax revenue.
sets the expansionary impact of higher wages on for- One reason why tax revenue held up relatively well
mal output. Formal sector employment can actually despite the sharp fall in formal output is that export
decline and while the real wage increases, other mea- taxes on resource-based goods increased since
sures of income inequality do not improve. The role exports rose as domestic demand fell. Higher export\
of the informal sector in these disappointing results along with lower intermediate imports due to the for-
suggests the need to develop programs which directly mal sector contraction. are responsible for the
focus on this sector in order to promote growth with improved trade balance. Once again. the CGE
equity. The macroeconomic effects of one such alter- methodology, and the corresponding disaggregation
native are investigated in the next section. of production across industries, allows us to see this
surprising result.
The results also indicate that significant changes
(c) A 10% increase in ir$>rmal sector productivig occurred within the informal sector following this
exogenous shock. While total informal etnployment
The final simulation involves a 10% increase in and production both increased. the number of infor-
 INFORMAL SECTOR AND MACROECONOMY
mal merchants fell by 6.6% as producers fled this
process. The combination of inelastic demand for
commercial services and the labor-intensive nature
of production caused the price and income asso-
ciated with this service to fall relative to other infor-
mal processes. As a result, informal producers left
this process for other informal processes where price
and income held up better.
While this movement within the informal sector
toward “productive” activities and away from ter-
tiary processes can be interpreted favorably, the real
income of informal producers is adversely affected.
Individual informal producers initially benefit from
greater productivity. but the subsequent indirect
effects associated with the macroeconomic adjust-
ment process are overwhelming. The terms of trade
for informal output declined by 5.2% which causes
the sharp deterioration in the income distribution.
The only bright spot appears to be a higher real wage
in the formal sector, but even this is tainted since it
reflects lower prices for informal output rather than
increased productivity here or gains in the distribu-
tional struggle with owners.
This simulation highlights the macroeconomic
limitations of strategies that promote capital accumu-
lation in the informal sector. An exogenous increase
in productivity causes total output to fall and reduces
the real income of informal producers. Informal out-
put does increase. but this does not increase the wel-
fare of informal producers since price of informal
output falls. Without income gains for its target
group. it is unlikely that such a policy will be able to
generate and sustain the necessary political support.
Thus despite the rhetorical appeal of this policy,
those concerned with the informal sector should
look elsewhere for economic strategies to help this
sector.
6. CONCLUSION
Despite the large size and economic importance
of the informal sector in the developing world, rela-
tively little is known about the macroeconomic
implications of these activities. Part of this reflects
inherent data limitations, but the lack of a macroeco-
nomic approach to the question of informal activity
has also been responsible. This paper addresses this
issue by developing a CGE model that explicitly
incorporates informal production where the lack of
formal employment drives this activity and the out-
put of the two sectors are treated as imperfect substi-
tutes. Informal output is divided into six processes
and simulations show how differences within the
informal sector, as between formal and informal
processes, have important macroeconomic and distri-
butional effects.
1405
The model’s response to various exogenous
shocks depends on competition between formal and
informal output, inter and intrasector labor migration
as well as macroeconomic conditions. The first set of
simulations showed that while the informal sector
did not change the model’s basic Keyneisan charac-
ter, it does affect the adjustment process and have
distributional consequences. The second set of simu-
lations examined the possibilities of wage-led
growth in light of Garcia’s goal of solidifying public
support through improvements in the income distrib-
ution. In contrast to standard structuralist models, the
results here are disappointing as both formal output
and informal sector income fall as higher formal sec-
tor wages cause informal output to replace formal
sector production. Workers who maintain their for-
mal sector employment experience higher real
wages, but displaced workers and informal pro-
ducers both suffer losses in real income. The last
simulation points out one problem with the argument
that the informal sector is the key to economic
growth in the developing world. Total output and
informal sector income both fell following an
increase in informal sector productivity.
Several general implications of this paper bear
special comment. The simulations have highlighted
the role of the informal sector in the adjustment
process and shown how informal activity alters the
effectiveness of macro policy. By disaggregating
informal production, the paper allows the informal
sector to react to changes in macroeconomic condi-
tions and relative prices within the informal sector.
These latter effects are often overlooked in discus-
sions of the informal sector, yet they are important in
order to understand the macroeconomic impact of
the informal sector. The ability to capture such
effects highlights one of the principal advantages of
the CGE methodology for this study. The paper has
also shown how the informal sector complicates dis-
tributional issues since formal sector wages and the
income of informal producers often moved in oppo-
site directions in the simulations. Such results are
important in that they highlight how informal acti-
vity compounds the difficulties associated with poli-
cies that are designed to improve the income distrib-
ution in developing countries. Thus despite the polit-
ical significance attached to rising real wages and
rhetoric calling for aid to the informal sector, this
paper argues the macroeconomic and distributional
impacts of such policies are likely to be negative for
much of the population. In fact, by placing informal
activity within a macroeconomic framework, the
paper shows that informal producers are better
served by policies which reduce informal production
through formal sector growth.
1406 WORLD DEVELOPMENT
I. See for example the book by Portes et al. (I 989).
2. Dervis, de Melo and Robinson (1982) provide
detailed development of the CGE methodology.
3. It is possible to include these goods in a CGE model.
Gibson and Godoy (1993) develop a CGE model of Bolivia
with cocaine production while Reardon (1984) includes agri-
cultural production for own use in a CGE of Peru.
4. It should be pointed out that small contribution by the
informal sector to total output of certain goods reflects the
requirement that informal output must be sold. For example,
to the extent that dwellings in pueblo jovenes are constructed
by residents, this output would not be counted in our defini-
tion of the informal sector. While this limits our analysis,
such an assumption is necessary in order to make the data
requirements reasonable.
5. Weeks (1975) also defines the informal sector by its
legal status. It is interesting that while de Sota works within a
neoclassical framework and Weeks a Marxian, they define
the informal sector in a similar manner.
6. See Carbonetto and Carazo ( 1986) Carbonetto, Hoyle
and Tueros (1987) and De Soto (1986) for various estimates
of the income of informal producers.
7. It is estimated that 43% of informal vendors work
without a fixed location (Carbonetto, Hoyle and Robinson,
1987, p. 340).
8. Taylor ( 1979, Appendix 6) provides a good description
of the linear expenditure system.
9. See Gibson, Lusteg and Taylor (1986) for a similar
treatment of commerce.
IO. This is obviously a skelatized view of public enter-
prises, but is sufficient given this model’s focus on the infor-
mal sector.
II For a foreign exchange constrained model of the Peru-
vian economy with informal production see Kelley (1990).
12. Carbonetto. Hoyle and Tueros (1987, p. 343) estimate
that 62% of the informal sector in Lima do not use machinery
and that the majority of equipment that is used in these activ-
ities is also use for domestic purposes.
13. Although measurements of informal sector income dif-
fer according to definitional and methodological issues. a
reasonable estimate places IS income at 67% of formal sec-
tor income (Carbonetto, Hoyle and Tueros, 1987). Of course
this does not account for differences according to industry,
location or length of the working day.
14. Note that with the Armington function, all purchasers
of the composite commodity buy the same combination of
formal and informal output of that good. While the makeup
of the composite commodity can change, it is not possible to
differentiate output based on whether it goes to intermediate
NOTES
or final demand. Obviously some informal output serves as
intermediate goods for formal firms, but this is given by the
a makeup of the composite commodity rather than explicit.
detailed links between the two sectors.
15. This setup is sufficiently flexible to include other
important characteristics of the informal sector. For example,
many women who work in the informal sector also have
childcare responsibilities which makes it impossible for them
to work away from the home. This could be modeled by
assigning some workers to certain informal processes perma-
nently or dividing the informal sector between work inside or
out of the home. For these workers, the relative income of
each informal process would not play a role in deciding
which informal process to operate. The impact of this restric-
tion on the simulation results would depend on the produc-
tivity of these processes as well as how the income of these
workers was affected by the exogenous shock.
16. These are standard structuralist assumptions as devel-
oped in Taylor (1979).
17. Daly (1976) and Reardon (1984). among others, make
the same assumption in their CGE models of Peru.
18. This implies that if informal processes need capital,
they must borrow, through intermediaries, the savings of
capitalists. In actual practice the informal sector is served by
a complex and well-developed system of financial interme-
diation. Without a full-fledged financial side to this model,
such questions cannot be analyzed.
19. This is a common assumption in CGE models and
made by Rizo-Patron and Reardon in their CGE models of
Peru.
20. It should be pointed out that reliable estimates of the
overall size of the informal sector in Peru vary considerably
due to definition, methodology and other factors. Furthermore,
reliable estimates of informal production at the sectoral level i\
even more problematic. As a result, the assumption made here
is certainly defensible and provides a size of the informal sec-
toral that is similar to other overall estimates.
21. Note this division does not correspond perfectly with
the definition of the informal sector used in this paper. For
example, household help would be included in the National
Accounts as paid labor. but is part of the informal sector in
this paper.
22. For example Carbonetto and Carazo estimate the size
of the urban, informal sector in 198 I to be I .2 million. The
difference however is partly attributed to the different defin-
ition of the informal sector as well as the fact informal activ-
ity in this study is limited to six processes. Estimates by ILD
place the size of the informal sector much higher, but again
the different definition combined with their inconsistent esti-
mates described by Rossini and Thomas suggest these fig-
ures are not reliable.
23. Carbonetto and Carazo (I 986, p. 138) estimate the cap-
ital stock associated with various informal processes.
 INFORMAL SECTOR AND MACROECONOMY
24. This procedure was developed by Stone (I 954) and is
explained in Taylor (198 1).
25. The two major problems were the fiscal and external
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Democracia, 1986).
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oping countries: Empirical evidence and policy implica-
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I, No. 2 (1986). pp. 28-35.
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#21 I (Washington, DC: World Bank, 1975).
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(1987). pp. 85 I-860.
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Ingresos (Lima: Centro de Investigation de la
Universidad de1 Pacifico, 198 I).
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Sender-o, ” World Development, Vol. 18, No. I (I 990).
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1408 WORLD DEVELOPMENT

APPENDIX A: EQUATIONS OF THE MODEL

1. Supply and demand balances for domestic goods (18 equations)

24
x b,,X,= 2 a,,X,+C,+I,+G,+E,+E, i=l,2,...,12
,=I ,=I

18 24 24

~(&~,b,~,-“‘+(I -6,) x b,J,m”‘)m”p’= Z a,,X,+C,+I,+G,+X, i = 13, 14,. ., 17

j= 19 j=I

19 24
p(S, ‘; b,,X;“+(l -6,) ‘; b,,X,m”‘)m”“‘= I; ( 1 g,,x,+ ;: B,,D,,) i= 18
,=I j= 19 ,=I ,=I f= I

2. Consumption demand (54 equations)

C,h=%+(‘h,,@,(l +p,,%,)))[(l -&)y,,- ; p,(l +f,&,)E,,-P&,1 i=l.2 ,.__, 17,19

,=I

3. Price equations (36 equations)

j=5.6....,18

p,=p,*e(1 -t,,)(l -P,,8,,) i= 1,2,3,4

f=4

P, = P, i=j=l.2,...,12

P, = 6,P, + (1 - 6,) P,,, i=j= 13. 14,. ., 18

4. Informal sector equations ( 12 equations)

X,lX,+, = (PJP,,,)’ [(S,Kl - 6,)l”’ i=j=l3,14,...,18

1,x,/L- t r,x,,=r,(P,-‘; P,,‘aJ’J j=l9,20....,24

j= I ,=I

5. Full-employment constraint (1 equation)

6. Income equations (3 equations)

Y, = zf
j= 19
(P, - ; I;,,ll,,, x,
,=I

Y,= C 1 ; P,b,,-(1 +T,,) ; $,a,,-yI,-P/*)X,-Z/l j=l,2 ,..., 9, 12. 13 ,.__, 18

I ,=I I=,
 INFORMAL SECTOR AND MACROECONOMY 1409

7. Government sector (3 equations)

,I 17
rP = c [ 1 P,,‘a,,+ w,l, + P,*m,,x, - z,
.,=I0 !=I
21 3 17 18 3
RR = 2 t,(wl, + P,,a, + P,*m,) X, + c t, Y, + Z t, P,*E, + 1 t,*P,*m,X, + C tr*P*eDT, + II8
j=l h=l i=, j=l f= I

9 = ; G, - R,
,=I

8. External balance (1 equation)

3 IX 4
P*e(CD~+~m~,=Z,*eE,+~ gk&+S*
f= I j= I i=l .f=4 i=5

Total number equations = 128, total number of variables = 127 where one of the labor allocation equations for the informal
sector is redundant.

Variable Name # of Variables

X; - primary output of process j 20

C,,, - consumption demand for good i by class h 54
6 - export demand for resource based good i 4
P, - output price for process j 24
p, - wholesale price of good i 18
K - income of class k 3
s* - foreign savings I
SE - government savings I
R’ _ total government revenue 1
fP - profit of government-run enterprises 1
Parameters
a, input of good i per unit of primary output of processj
m/ import-output coefficient for process j
1, - labor-output coefficient for process j
b,, - output of good per unit of primary output of process j
1, - Investment demand for good i
G - Government demand for good i
E, - Export demand for non-resource based good i
% - subsistence consumption of good i by class j
hi - marginal consumption propensity for good i by class h
8*,J - physical commercial margin on good i per demand type
$ - physical commercial margin on good i for process j
P* - international price of imports
P,* - international price for resource-based good i
5 - markup in process j
t, - indirect tax on output of processj
t* - tax on imported good used in process j
:, - export tax on good i
t’h - income tax rate on class h
6, - informal sector parameter i
I4 elasticity of substitution between formal-informal output
8, - constant for Armington function
QI - coefficient for informal sector labor allocation
5 constant for informal sector labor allocation equation
L - total labor force
- average savings propensity for class h
2 - total depreciation for process j
e - exchange rate
M’ - nominal wages
 APPENDIX B: SOCIAL ACCOUNTING MATRIX FOR 1985
P
z
Food/Process

M-Int M-Int H.Man. FOIilUl Inf

Food Colt Int K w/few Govt. Govt. Prof. Light Light FOtTllkll Inf Formal
Agric. Fish Petrol Mining PrC%eSS Goods Goods Good5 Imports Infrast Serv. Serv. Man. Matl. Text Text Const

Agriculture 1730 4 0 24 7452 1904 40 0 I 0 62 20 I98 138 644 486 x3

Fish 0 415 0 0 395 0 0 0 0 0 9 3 II 0 0 0 0
Petroleum 121 98 16226 512 23X 53 1154 23 416 477 I84 XI2 74 56 52 51 129
Minerals 57 3 6 3140 I5 1 940 593 IX9 7 1 9 206 I21 0 0 169
Food 2462 27 s 26 1130 306 330 I 0 I 201 I03 68 45 71 53 0
Imp-Int con goa% 235 2 8 30 157 1756 16 2 0 4 119 597 5 2 3 0
Imp-Int int. goods 979 119 136 634 525 174 6556 484 160 90 129 271 546 234 379 204 745
K goods 24 I9 28 77 92 39 359 225 73 215 XX 299 X6 2x 32 I0 69
Heavy man 0 3 0 II2 66 61 186 13 306 6 IX 103 36 I6 4 0 964
Govt infrast 3 25 13.5 659 293 63 x90 so 174 163 II.5 624 85 70 45 45 13
Govt services 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
Prof services 739 150 IO24 655 242 I75 1227 146 77 452 313 10962 I53 60 132 44 580
Light manuf 52 19 I7 4x 231 II8 476 77 I78 139 I92 122x 1324 1006 61 75 294
Textiles x9 7 2 24 154 89 XX 45 II 21 103 59 133 xx 2186 1788 0
Construction 0 0 116 2 I9 7 53 II 5 II9 202 422 I3 s 8 5 0
Commerce X27 7s 761 412 I543 XXI 1651 273 244 I54 333 657 591 305 533 372 s4x
Surface tramp 250 40 2131 402 404 137 898 93 374 31 IS 480 133 75 50 33 I04
Diverse services 66 IO 41 22 I40 Y4 352 76 32 76 I46 819 41 27 26 I9 60
Total int. cons 7634 I(116 20696 6784 13096 5864 15216 2112 2240 1955 2236 1746X 3692 2276 4226 3185 3758
net Joint production -1157 -90 -534 -743 648 -306 -1514 30 -156 89X -68X 661 -63 0 -14 1243
Total value added 22918 858 I x073 9753 4965 1664 8120 I660 1976 3291 10779 22339 2323 I964 I446 2026 57%
Private income 22753 77s 10791 x374 3049 IX20 6881 1537 2034 1611 I0266 21452 2128 1964 136X 2026 5470
Wages 4822 307 IW 1555 1003 622 2733 654 533 I611 1026h 7924 823 689 235 I
IS income 1964 2026
Profits 17931 468 9727 6819 2046 1198 4148 8X3 1501 13528 1305 679 31 I9
Government income
Indirect tax\ 165 X3 72X2 1379 1916 -156 1239 123 -58 I h8ll 513 X87 I95 78 285
Sales tax I5 3 s214 60 1582 I52 x77 123 214 403 0 505 173 I59 9
Tax on exports -x 65 2006 119Y 293 -3 -382 -98 -342 0 0 X 46 -153 0
Other tax IO I2 I4 31 93 46 I48 31 39 77 173 227 44 3x 83
Impon tax 148 3 JX X9 -52 -3s I 596 67 31 I? 340 I47 44 34 lY3
Direct taxes
Profit on govt firm\ I241

23x 66 72X 243 90 525 74 II4 310 I IX1 II4 0 I36 340

Imports (FOB value) 827 494 760 1881 3586 414 I52 57 251.1 I X42 362 0 197 0 2138
TOTAL 30361) 17016 19712 ‘)I93 2.5933 12YO 4326 651 I I+)60 1349 I 642X 4240 599 I 521 I 13534

Appendix B. Cont.
 APPENDIX B: Continued.

FOlllltd Inf Formal Inf Total Total

Inf FOl-lKd Inf surf surf DiV Div Int Formal IS Capit- Private Govt. Total Final Total
cons Comm Comm Trail TKitl Sen’ Serv Demand Wrks Wrks abst Consump. Expend Invest Exports Demand Demand

Agriculture 6 I 0 0 0 342 85 I3220 7091 5045 4303 16439 7 218 576 17240 30460
Fish 0 0 0 0 0 41 10 873 I31 72 95 298 0 0 699 997 1870
Petroleum 23 90 39 1273 1273 32 8 23414 2078 1366 3007 6451 0 0 8939 15390 38804
Minerals I3 2 0 3 0 0 0 5487 0 0 0 0 0 0 II529 II529 17016
Food 0 0 0 0 0 1682 474 6985 4516 2342 3838 lo696 0 0 2031 12727 19712
Imp-Int con goods 0 0 0 2 0 233 26 3197 2462 1916 1569 5947 0 0 49 5996 9193
Imp-Int int. goods 23 122 22 377 94 577 64 13644 2670 676 4702 8048 101 2034 2106 12289 25933
K goods 2 3 0 9 4 109 I2 1902 0 0 611 611 38 1377 362 2388 4290
Heavy man 72 24 4 0 0 71 8 2073 0 0 1039 1039 0 0 1214 2253 4326
Govt infrast I I82 I21 IO 8 I35 55 3964 842 296 1409 2547 0 0 0 2547 6511
Govt services 0 0 0 0 0 0 0 0 0 0 0 0 14960 0 0 14960 14960
Prof services 44 1509 226 710 395 583 146 20744 5655 I910 8494 16059 0 0 6688 22747 43491
Light manuf 33 173 II5 41 40 64 39 6040 I502 725 1485 3712 67 300 549 4628 10668
Textiles 0 67 44 I2 7 120 40 5182 1806 793 2222 4821 I3 59 1127 6020 11202
Construction 0 0 0 80 22 0 0 1149 0 0 0 0 6131 7237 0 13368 14517
Commerce 50 101 39 140 81 690 130 II691 7875 4396 9289 21560 124 2181 2064 25929 37620
Surface transp I7 3176 1427 I82 I21 I7 4 10594 4687 2456 3217 10360 0 0 0 10360 20954
Diverse services 5 496 169 2411 2230 432 I44 7934 4465 2050 8237 14752 0 1293 242 16287 24221

Total int. cons 289 5946 2206 5250 4275 5128 1245 138093 45780 24043 53517 123340 I4699 38175 197655 335748
net joint production 1636 -43 192
Total value added 694 16193 1407 5656 4647 12927 174739

Private income 694 15903 1407 5602 4647 12519 158376 174773
wages 4223 1451 3788 46419
IS income 694 1407 4647 24043 158376
II680 4151 873 1 52969

Government income 21370

Indirect taxes 290 0 54 408 16363
Sales tax 221 0 0 164 9874 9874
Tax on exports -239 0 0 0 2280 2280
Other tax 292 0 I9 48 1370 1370
Import tax I6 0 35 196 1598 1300 1300 32 0 2396 3994
Direct taxes 639 1972 2611 2611
Profit on govt firms 1241 1241

Savings 23256
sav bus I44 984 5962 26885 26885 5962
sav HH -358 26885
wv Govt 4240 4240 255 -9233 -358
sav For 0 -9233

Imports (FOB value) 0 88 0 I85 0 967 16954 4240 4240 255 7493 0 11988 28942

TOTAL 983 24007 13613 12032 8922 19671 335748 24043 87914 158376 21370 23256 28942